ETF and index investing “supports vibrant capital markets”, argues BlackRock, the world’s largest asset manager, in a research paper released in response to some commentators’ warnings about the perils of passive products, including ETFs.

ETFs ‘support vibrant capital markets’, says BlackRock.

BlackRock is weighing in on the debate over the potential impact of the continued growth in passive investing on capital markets. Specifically, some investors are fearful this trend may negatively affect price discovery, reduce competition between firms due to common ownership, and cause market volatility to increase in the event of a crash.

In the last few years, passive investing has been called Marxist, communist, and even evil!

However, the paper’s authors propose several points to rebuff these claims.

Firstly, they point out that despite its growing popularity the relative scale of index investing is still small – index funds and ETFs together represent just over 12% of the US equity universe and 7% of the global equity universe.

The authors note that, while index investing is currently growing at a faster rate than active strategies, the balance of active and index management is self-regulating. “Underperformance by many active strategies has helped increase the appeal of index strategies,” the paper states. “If index investing were to grow large enough to affect price discovery, any short term price fluctuations of individual stocks would be used by active managers to improve their performance. Improved active performance would attract flows back into active strategies. Intuitively, the market will continuously adjust to an equilibrium.”

Addressing concerns over the potential for passive investing to negatively impact price discovery, the authors argue that, due to its relatively low turnover and small size compared to active strategies, trading driven by index investing plays a small role in the price discovery process for individual stocks – for every $1 of US equity trades driven by index strategies, managers seeking active returns (in excess of benchmark) trade approximately $22.

The paper further notes that the trading of ETF shares on exchanges in the secondary market does not directly drive buying and selling of the underlying stocks. Additionally, purchases and sales of stocks driven by the ETF creation and redemption process account for only 5% of all US stock market trading.

Thirdly, the paper discusses the concern that index funds may drive investment flows into the asset class, sector or region of the moment, only to see a rapid decline when sentiment reverses.

The authors contend that “in practice, investment products are tools for implementing the individual asset allocation decisions that are made by asset owners. In the absence of index funds, these asset allocation decisions would be executed via an alternative means, such as individual stocks or active funds.

“The vast diversity of index benchmarks, strategies, and products means that index assets are not limited to flowing into (or out of) a small set of static strategies, but rather are dispersed widely throughout the investable universe. Moreover, indexes themselves are not static. The stocks included are rebalanced periodically, reflecting the dynamics of the competitive landscapes that they track.”

The paper goes on to say that while differentiating between active and index strategies is often a useful shorthand, in practice the investment landscape is not a binary choice between two styles, but rather represents a continuum of investment strategies that range from fully active to index driven. As a manager of both active and index-based investment solutions, BlackRock sees important and complementary roles for both.

The paper moves on to discuss claims surrounding the potential negative impact of ‘common ownership’, the conflict of interest arising from asset managers owning relatively large percentages of firms competing against each other. Acting in their shareholders’ best interests, the theory states it is reasonable to assume that they might start colluding to increase prices since they have common shareholders.

To counter, BlackRock’s research report notes: “…we believe that these theories rest on some fundamental misconceptions, and do not provide a plausible causal explanation. A growing number of more recent academic papers challenge the assumptions, methodology, and conclusions of the original academic work on this topic, as part of a robust academic dialogue.”

BlackRock notes that advances in technology have extended the range of investments that can be indexed, providing choices beyond the traditional market cap-weighted indexes to more dynamic indexes, such as those tracking investment styles, and value or quality stocks.

BlackRock reports that the global trends driving the adoption of index investing strategies include: growing awareness of the value proposition they offer, in seeking to track rather than beat a benchmark index; increased focus on fees and transparency by regulators and investors; and the shift in brokerage and advice models that has seen investment advisers increasingly act less as stock or fund selectors, and focus more on building diversified portfolios, often delivered through index funds.